Adjustable Rate Versus Fixed Rate Home Loans

Posted by Lee and Katherine Keadle on Monday, April 29th, 2013 at 4:06pm.

mt pleasant memorial waterfront park

What is the difference between an adjustable rate and a fixed rate loan? Adjustable rate loans (or ARMs) can be tempting because of the lower initial interest rate, but they come with some risks. It is very important to be educated on the interest rate environment, the local Charleston real estate market, and how ARMs work. You also need to be quite certain of how long you will own the home. Fixed rate home loans generally have a higher rate, but they provide more security with regards to your payment amount and interest rate. Fixed rate loans are seen much more in Charleston than they were back in early 2000.

Adjustable rate mortgages offer many attractive advantages. ARMs have lower rates and lower payments at the beginning of the loan term. Borrowers are able to save and invest more money, and they are able to buy larger homes because their monthly payment will be lower for qualification purposes. A person who has a payment that is $100 less with an ARM can place it in a higher-yielding investment. Instead of refinancing and paying to take advantage of falling interest rates, borrowers in the past have been able to sit back and watch their payments fall automatically.

The disadvantages of adjustable rate mortgages are not to be taken lightly. Payments and interest rates can rise significantly over the life of the loan. For example, a 5 percent loan can escalate to 11 percent in only three years if rates increase quickly. The first rate adjustment can hit hard because some annual caps do not apply to the first rate change. ARMs are difficult to understand, so it is imperative that only sophisticated borrowers use this loan type after carefully calculating their worst case scenario. ARMs are typically not useful as a long-term loan. Most borrowers who choose these plan to sell the property within only a few years.

Fixed rate mortgages are predictable and remain constant. If you do not like surprises, then fixed rate is probably the loan for you. Even if mortgage interest rates sky rocket and inflation goes up quickly, you will still be liable for the exact same payment as you were when you first bought the home. The only variables that will change are your insurance, taxes, HOA dues, and utility bills. Fixed rate mortgages are easy to understand, and the certainty of your monthly payment makes it much easier to budget household expenses. The only disadvantages are that you will have to refinance and pay closing costs to take advantage of falling rates in the future (since current interest rates are at historic lows, this scenario is not very likely). Also keep in mind that you may qualify for less. Overall, fixed rate mortgages are much less risky.

It is a good idea to ask yourself a few questions if you are considering both of these loan types:

What is the Charleston real estate market like?

Right now, the Charleston real estate market has much less inventory combined with a growing demand for homes. This means we are in a sellers’ market with multiple offers occurring at a high frequency. This is currently pushing up housing prices. Your real estate agent should be able to give you enough information about the specific neighborhood to help you make an educated guess about its future value. If you are uncertain about being able to sell your home in a few years, an ARM is not your best option. You most likely will be able to sell your home in a few years in Charleston for more than you paid, but there is never a guarantee. Being able to afford your payment is imperative for a worse case scenario in which prices deflate and you are unable to sell.

How long do you plan on owning the home?

If you are certain that you will only own the home for a few years, it might make sense to consider a lower rate, lower payment ARM. You could save more money for a larger home in the near future or use the savings to invest in a higher yield investment. You probably will not see a rate spike because you will be selling in the near future before your ARM gets a chance to increase too much. Even if you plan to sell within a few years, consider your worst case scenario of not being able to sell (if the real estate market were to take a dip).

How often does the ARM adjust, and when does it adjust?

After the typical initial fixed period, ARMs usually adjust annually on the anniversary of the mortgage. However, some adjust on a monthly basis. The adjustment is based on a specified index. It is common to see an ARM that has a cap, meaning the interest rate can only go up 2% maximum each change period, for example. It is extremely important to pay attention to when and how your payments will be adjusted.

What is the interest rate environment like?

When rates are higher, borrowers tend to take advantage of the lower rates of the ARMs so they can qualify for a more expensive home. If rates are falling, it may make sense to do an ARM in order to get the lower rate each time mortgage rates fall without the expense and hassle of refinancing. However, when rates are lower (as they are right now in the current market), fixed rate mortgages are much more desirable because they are affordable and less risky.

Could you afford a significant increase in your monthly payment?

If your mortgage rate shot up from a 3 percent ARM to a 10 percent ARM (and your monthly payment shot up with it), would you be able to make your mortgage payment – or would you lose your home and destroy your credit? In making the decision to finance your home using an ARM, it is wise to make sure you could cover the payment if it shot up significantly. Do not depend on being able to sell or refinance to get you out of your loan. Prices of homes could potentially fall with an increase in rates, leaving you with little or negative equity – meaning that you will not be able to refinance or sell your home.

Even the most savvy or experienced borrower should consider all aspects when deciding whether to go with a fixed rate loan versus an adjustable rate home loan. Doing your homework and being farsighted about the worst case scenario is always a prudent plan. When in doubt, borrowers in the Charleston real estate market are safest to choose a fixed rate mortgage because their rate stays constant, and there are no surprises.

Leave a Comment